Germany's Tightrope Act

BERLIN—Germany, uniquely, is prospering while the rest of Europe sinks deeper into recession. And the recession is substantially the result of the very austerity that Chancellor Angela Merkel is imposing on the other member nations of the European Union.

Why is Germany spared? One good reason and two bad ones.

The good reason is that Germany promotes manufacturing, with sensible training and technology policies. Its industries have partnerships with effective unions. So Germany’s huge export surplus means that it can have tight budget policies at home and still have plenty of good jobs.

A bad reason is that the same euro that is overvalued for Greece is undervalued for Germany. So Germany benefits from a tacit subsidy—an artificially cheap currency, which makes its exports cheap. The second bad reason is that as capital flees from weak economies, it comes to Germany, leaving Germans with artificially low interest rates—another subsidy at the expense of its neighbors.

But even Germany’s economy is beginning to slow, as its customers go deeper into recession. About 40 percent of German exports go to the rest of Europe.

The question that people here is asking is whether Chancellor Merkel can be persuaded to change her austerity demands before the entire European project collapses.

The timing will be very tight, since Merkel is not likely to alter her views until Europe is about to go off a cliff, and that may be too late. Think of the catcher in a trapeze act, who has a less than a second to grab her tumbling partner before the partner falls to the ground.

The Germans favor tight budgets not just because the memory of the 1923 hyper-inflation makes the culture inflation-phobic. It’s also the case that the 1990 re-unification with communist East Germany cost something like two trillion dollars, increasing deficits and causing the German Central Bank to raise interest rates to guard against inflation.

In 2009, even the opposition Social Democrats joined in supporting a constitutional amendment known as the debt-brake (schuldenbremse), requiring a balanced budget. Budget balance here is tantamount to virtue, and deficits are considered living in sin.

Thus, when the Greeks required a bailout in 2010 after hedge funds began speculating against their government bonds, Merkel initially refused, then relented but only on condition that Greece agree to a stringent austerity plan. As a consequence of deep austerity in a deep recession, Greece will lose a staggering 25 percent of its GDP in four years.

Just to hammer the point home, last year Merkel sponsored a fiscal pact to be approved by the EU’s member nations, providing sanctions for nations that failed to keep their deficits and debts within narrow limits. As a condition of receiving emergency aid, nations were required to sign the pact.

In effect, she created a self-annihilating system like one of those novelty machines where you turn the device on, and then a hand comes out and turns it off. The bail-out funds help Greece survive, and then the austerity program kills the Greek economy.

Now events have turned critical for the rest of Europe. Talk of lopping off Greece and building a firewall around the rest of the EU is a fantasy, because speculators are already assaulting the government bonds of Spain and Italy. The EU emergency funds that have been created do not have enough money if Spain and Greece totter.

Merkel is at odds with the Spanish government over the terms of a bail-out for Spanish banks.

Two crucial events this month are the Greek elections on June 17, and then a summit of European leaders June 28-29. Expectations are that Merkel will agree to some “growth” elements to offset her austerity policy. These might include expanded investment funds for Europe’s peripheral economies, and perhaps the segregation of bad debt, with longer payoff terms. But these measures would not be sufficient to head off Europe’s larger crisis.

As a leader of the German labor movement told me, the best stimulus program for Europe would be to abandon austerity. And Merkel is far from agreeing to that.

As Europe’s real economy keeps sinking and the bonds and banks of larger nations like Spain and Italy suffer increased capital flight, there is a real risk that the EU could crack in two. Germany, France, the Netherlands, and a few other nations would continue to use the Euro, and the southern nations would be cut loose. With so much trade and finance in Euros, this would bring incalculable costs, not just to the weaker nations but to the European economy and the 60-year project of European unity.

As she looks over the precipice, and begins hearing from her own constituents in Germany’s business and banking elite, will Merkel relent? And what would it mean to relent?

The best idea I’ve heard comes from the DGB, Germany’s counterpart to the AFL-CIO. The idea is to empower a true central bank to create money and to support bonds and banks at a sufficient scale to end the speculation against Europe’s weaker economies and to recapitalize its banking system.

This, in effect, is what the Federal Reserve and the Bank of England have been doing ever since the financial crisis broke out. There is no serious speculation against US or British Treasury bonds, because their respective central banks have made clear that they will buy government bonds as necessary. (Isn’t that risking inflation? Evidently not; long term interest rates are at record lows.)

The current ECB is constitutionally prohibited from acting like the Fed. But the DGB’s idea is to give the bailout fund, technically known as the European Financial Stability Facility, a banking license and then the ECB could advance it money as necessary and the Fund could invest in banks and bonds.

Given Merkel’s ideology and past performance, this idea is about as heretical as one could imagine. Embracing it would be like Nixon-to-China, and then some. The question is whether Merkel would prefer the breakup of the EU and a prolonged depression.